Yahoo Finance What Is Peer-to-Peer Lending and When Should You Consider It?
Peer-to-peer lending can be the answer to all kinds of situations in which you need to get your hands on some cash. Maybe you want to reduce or consolidate debt, buy a car, start a small business, pay for a wedding or replace a washing machine that just died.
Maybe friends and relatives can’t lend you the money, or you’re afraid the banks will deny your loan application. If you want to avoid accumulating credit card debt, a peer-to-peer (P2P) loan could be the solution for you.
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On the other side of the equation, P2P lending can be a great opportunity if you’re looking for an innovative way to invest your money. As an investor in P2P loans, you can earn some passive income while diversifying investments and potentially lowering your overall risk. Read on for a further explanation of P2P lending and when it might be right for you.
What Is P2P lending?
Peer-to-peer lending — aka person-to-person, P2P or social lending — anonymously matches up borrowers and lenders via an online platform using complex computer algorithms. Here are the basic facts about P2P lending:
Personal loan amounts typically range from $1,000 to $50,000. Higher amounts might be available for small business loans and lines of credit.
Terms of the loans typically range from one to five years.
Borrowers make fixed monthly payments that are automatically deducted from their verified bank accounts.
There are no physical branches in the P2P lending marketplace, potentially lowering costs for borrowers and increasing returns to lenders. The lending platforms make their money by charging origination fees to borrowers and deducting fees from the loan repayments made to investors.
P2P lending began over a decade ago. Prosper launched in 2006 as one of the pioneers of online marketplace lending. Avant and Upstart are currently the main competitors. LendingClub was one of the top competitors until it left the P2P space in 2020 to transition towards becoming an online bank.
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Criticisms of P2P Lending
Time reported that all might not be rosy in the world of P2P lending. In March 2016, the Consumer Financial Protection Bureau started accepting Prosper and Lending Club reviews and complaints. This policy was put in place to put regulatory pressure on the P2P loan industry, which had seen an increase in loan delinquencies.
LendingClub eventually had to pay $18 million to settle charges with the FTC after being sued for charging consumers hidden fees and providing inaccurate information about loan application approval. The platform was ordered to return more than $10 million to over 15,000 consumers hit with undisclosed fees. With such a major player in the P2P space leaving the industry, this was certainly a red flag for those thinking about entering the space.
Pros and Cons of P2P Lending for Borrowers
For borrowers, getting a small personal loan via P2P lending can be an attractive alternative to dealing with traditional banks. Investors can add P2P loans to their portfolios to diversify their investments and reduce some risk.
No matter which side of the equation you’re on — borrower or lender — you need to carefully consider the pros and cons before you take the P2P plunge.
Pros of P2P Lending for Borrowers
There are a number of advantages to this online borrowing option compared with credit cards or traditional personal loans:
Easy, fast online application process
May get approved for a loan after being denied by a bank
No impact on credit score for checking your interest rate
Lower interest rates compared with some credit cards and traditional financial institutions
Fixed interest rates and monthly payments with no hidden fees
You remain anonymous to your lenders, and they won’t contact you directly
No prepayment penalty if you decide to pay off the loan before its due date
Loans are unsecured, so you don’t have to provide collateral such as the title to your car
There’s a social aspect because you get to “watch” online as investors fund your loan up to its total amount
You can apply for additional online loans if you handle your initial loan responsibly
Cons of P2P Lending for Borrowers
Although the P2P platforms tout many benefits on their websites, there are some disadvantages you need to be aware of before you commit to borrowing:
You can’t always borrow your way out of debt. Investment and chartered financial analyst Joseph Hogue said that the most popular form of P2P loans is debt consolidation loans, but even this alternative funding can backfire if you don’t fix the spending problem that got you in debt in the first place. “If you constantly spend more than you earn, you’ll never get out from the debt trap,” said Hogue. On top of the interest rates, you also have to worry about the origination fee and other possible hidden costs.
High interest rates apply. If you have less than good credit, you’ll get stuck with a high-interest rate, which will cost you more in the long run. It might be better to wait and improve your credit before you apply.
Borrowers with bad credit might be out of luck. “Credit scores below the cutoffs are not usually approved. Rates for borrowers at the low end of the scale will be 25 to 35 percent,” Hogue said. That’s not much better — and might be worse — than the interest rates on credit cards for people with bad credit.
Serious consequences apply if you don’t handle your P2P loans properly. “Don’t think that just because loans are unsecured that they don’t need to be paid. A missed payment will hit your credit score just as badly as any other type of loan,” Hogue said. “Worse still, many P2P investors won’t loan to someone with a missed payment, so you might be ruining your chances at getting another loan.”
Pros and Cons of P2P Lending for Lenders
Pros of P2P Lending for Lenders
Investors have many choices for investing their money: stocks, bonds, CDs, mutual funds, real estate, or businesses, to name a few. Being a P2P lender is an alternative to those more traditional choices — one with many attractive advantages:
Lenders can be individuals or institutions
Easy to open an investment account online
The initial investment in each loan can be as low as $25 [x]
You can invest in a portfolio of hundreds or even thousands of loans
Receive monthly payments of principal and interest as the borrowers repay their loans
Diversify your risk across many different loans rather than making a single loan or investing only in stocks
You can choose whether to reinvest the payments you receive or withdraw the funds from your P2P account
You can earn higher rates of return on your money, reaching 5 to 9% based on your investments. [x]
You can choose what you invest in, from a small business project to helping someone remodel their home.
Cons of P2P Lending for Lenders
Although rounding out investments with peer-to-peer loans might be an attractive option, investors should be aware of potential disadvantages:
The risk of losing all your money still exists. If you jump to invest in only the high-risk-category loans with double-digit interest rates, you can easily lose all your money, just like any other investment. “Don’t chase high returns without understanding the risk that comes with it,” said Hogue. “You can invest as little as $25 in each loan, but you’ll still need about $3,750 to invest in enough loans so that a few defaults don’t wreck your overall return.”
You need to diversify. To maximize your investment, diversify by investing in the right number of loans in several risk categories. Hogue recommended a portfolio with between 125 and 175 loans.
P2P investing isn’t a get-rich-quick scheme. You’re stuck with the loan for the term you committed to, which could be up to five years. You can’t cut your losses and sell the loan. On the other hand, Hogue pointed out that this might be advantageous for some investors because it prevents panic-selling, helps investors avoid high trading fees that come with the stock market, and makes P2P loan investing more of a fixed-income type of investment.
P2P Lending vs. Other Options
When should you consider a P2P loan compared to other options as a borrower and lender? As a borrower, you have other options, such as:
Home equity loans. You tap into your home’s equity to access more funds at a lower rate. However, you’re taking a risk by using your home as collateral.
Traditional bank loans. You can apply for a traditional bank loan if you qualify and meet the eligibility criteria.
Credit cards. Even though the interest rates can be exorbitant on credit cards, you have instant access to cash when you need it.
Your decision may ultimately depend on your credit score and eligibility, as these factors will greatly impact your options as a borrower.
For individual lenders, adding P2P loans to your portfolio is a way to diversify your investments and potentially lower your overall risk. However, it’s worth noting that you have various other safer investment options, ranging from high-yield savings accounts to CDs if you’re looking for better returns. In either case, you need to consider the pros and cons of P2P lending before taking the financial plunge.
Martin Dasko contributed to the reporting for this article.
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This article originally appeared on GOBankingRates.com: What Is Peer-to-Peer Lending and When Should You Consider It?
